An extremist, not a fanatic

February 28, 2015

I'm in two minds about Frances' critique of macroeconomics. A bit of me disagrees, but a bit thinks she might be understating the problem.

First, a disagreement. In one respect, the 2008 crisis actually strengthened economics. The investor who followed the sell in May rule, or who used foreign buying of US equities as a sell signal, would have been out of equities before the crash of 2008. In this sense, the financial crisis actually vindicated the claim that economists can fulfill the useful function of warning of trouble ahead.

Of course, these two guides told us nothing about the causes of the crisis. But we must remember Jon Elster's words:

Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. (Nuts and Bolts for the Social Sciences, p8)

I also disagree with this:

The failure of most macroeconomists to foresee the financial crisis grew out of their incorrect understanding of how money is created, and perhaps more importantly, how leverage builds up.

However, most banks didn't fail merely because their debts turned bad. They did so because of bad takeovers (eg RBS-Amro or Lloyds-HBOS) and/or a reliance upon wholesale finance. These were not so much macroeconomic failures as micro ones - bad decisions by individual businesses*. As the TSC said (pdf):

The origins of the banking crisis were many and varied, including low real interest rates, a search for yield, apparent excess liquidity and a misplaced faith in financial innovation. These ingredients combined to create an environment rich in over-confidence, over-optimism and the stifling of contrary opinions.

In this sense, the bank crisis was an example of what Xavier Gabaix called the "granular" origin of aggregate fluctuations. Recessions can result from the failure of individual firms.

What matters here is the structure of economic networks: see for example this paper by Daron Acemoglu and these papers in the JEP. Bank failures matter because banks are key hubs, in three different senses:

- Banks emulate each others' strategies. As Frances says, they herd. The failure of one is therefore likely to be correlated with the failure of others.

- One bank's failure will have a chilling effect on others; they'll try to hoard cash by withdrawing credit.

- Non-financial firms can't easily switch away from bank finance. As an empirical matter, private equity, P2P lending, crowdfunding and suchlike were not sufficient to replace lost bank credit. For this reason, the collapse of RBS was not like the demise of Woolworths. People could easily get their pick n mix elsewhere; they couldn't so easily get finance elsewhere. For this reason the collapse of banks had horrible macroeconomic effects.

It's for this reason that I say Frances understates the problem. The flaw with representative agent models isn't that they ignored the financial sector or that they forgot that "expectations are driven as much by emotion as logic." These problems are fixable. The problem is that recessions sometimes arise from interactions between firms and from firms position within networks; the failure of a hub matters whereas the failure of a spoke doesn't. Representative agent models, by definition, omit this. To this extent, we need a different paradigm. And perhaps this paradigm will only ever allow us to understand events after the fact rather than predict them.

We must, however, remember something else. Even if we had a fantastic macroeconomic theory, there is no guarantee whatsoever that governments will use it for policy purposes. As Simon says, we have a perfectly good theory of what fiscal policy should be at the ZLB - and it is being ignored.

Explanation and prediction are two different things. And good policy is a third different thing.

* Caveat: a current account deficit means that domestic investment exceeds domestic saving. This implies that domestic banks' lending might well be rising faster than deposits, implying a reliance upon other sources of funding.

February 27, 2015

Simon's claim that fiscal austerity has been a disaster reminds me of a big bias in the media - the misuse of the word "cost".

Very often, when the press use the word "cost" to describe a policy, what they really mean is a transfer. For example, the BBC says that "offering four weeks paid paternity leave will cost £150m a year". No, it won't. This is a benefit for working fathers but a cost to their employers. This is a transfer, not a cost. Similarly, the Guardian writes: "A cut in the cap on tuition fees would cost just under £2bn." It might cost universities that, but it'll benefit future graduates. Again, it's a transfer - not a pure cost.

Of course, these might well be bad policies. And there might be all sorts of deadweight costs to transfers or dynamic disincentive effects. Once you've estimated these, you can reasonably describe your estimate as a "cost". What you should not do is claim that a transfer the same as a cost.

You might think I'm being pedantic here. I'm not. For one thing, wibble about "cost" can be used to hide the fact that some policies are a positive benefit. For example, in his interview with Natalie Bennett Nick Ferrari spoke of the "cost" of building houses. Ms Bennett should have replied thus:

There is no cost. It's a net benefit. The government can borrow at 2% but charge rent on the completed houses of 4-5% and have a capital asset to boot. If housebuilding is a cost, how come Bovis and Persimmon this week reported big profits? What's more, there are benefits to future renters who get somewhere to live, and to currently unemployed workers who'll get jobs. The only losers are existing home-owners and landlords who'll see lower gains in future because houses will be less scarce. Net, it's highly likey that housebuilding will be a benefit.

There is, though, something even more pernicious going on, which is where Simon comes in. When he estimates that austerity has cost 5% of GDP, he's using cost in the proper sense - of something that leaves us all worse off than we'd otherwise be. Similarly, when he claims that leaving the EU will cost at least 2.2% of GDP, John van Reenen is using the word properly - though you might disagree on his estimate.

The sums here are huge: 5% of GDP is £85bn - vastly more than the few hundreds of millions "cost" of some Labour policies.

And yet most of the media is much quieter about these genuine costs than they are about the spurious "cost" of other policies. Why?

It's not just because of an explicit Tory bias. Even the BBC talks about cost in the wrong sense. I suspect that two other things are going on.

One is a form of certainty effect. There is rough bi-partisan agreement upon the Exchequer cost of transfers to fathers, students or whoever whereas Simon's estimate lacks such consensus. In the world of "due impartiality", the truth is defined as "what people agree about" rather than what is actually the case. And so the word "cost" is misused.

Secondly, there's the fallacy of the "nation's finances"; politicians and the media routinely use this phrase to mean something utterly different - the government's finances. If you commit this error, then you'll believe the cost to the Exchequer is a cost to the nation - when it is no such thing. Whatever the origins of the error, though, it is a deeply pernicious one. It tends to present any party wanting to increase borrowing as profligate - as imposing costs upon us. But in fact, the true costs are imposed by the parties that have trashed the economy.

* The error I'm describing isn't confined to the right. Leftists also make it when they talk about the "cost" of tax-dodging. This too is a transfer - from the Exchequer to tax-dodgers.

February 26, 2015

Ed Miliband is right. MPs should be banned from having paid directorships and consultancies. However, I don't say this for the conventional reasons.

It's not because such jobs distract MPs from their duties to voters and the country. The way to stop an MP doing a lousy job isn't to stop him doing other jobs but to ensure that he gets either deselected or voted out. In this context, stronger powers of recall would be better than a ban on outside work.

Nor is it because such directorships will lead to MPs' votes being swayed by specific commercial interests. As Simon says, the solution to this is to have tougher rules preventing such interests from influencing votes.

Instead, I'm thinking of the mere exposure effect: people tend to like things simply because they are familiar with them. Some experiments (pdf) by James Andreoni and Justin Rao illustrate an important variant of this.

They got people to play a simple dictator game, in which people were asked to split $10 between themselves and a partner. They found that when the dictator and the partner were not allowed to communicate with each other, dictators handed over an average of $1.53. However, when subjects were allowed to ask the dictator for a donation, the dictator gave an average of $2.40. This tells us that communication increases sympathy, even if it leaves incentives unchanged.

Herein lies the danger with allowing MPs to take directorships and consultancies. In causing MPs to associate with rich businessmen, they will bias MPs' sympathies towards the rich. This violates the democratic ethos, which says that political influence should be equalized.

Two things exacerbate this danger. One is that the converse of the communication effect is also true. Experiments by Agne Kajackaite have shown that people are more likely to behave badly if they are ignorant of the victims of their behaviour. If MPs don't associate sufficiently with the worst off, they might therefore become less sympathetic to them.

The other is that MPs tend to be personable types: you couldn't cope with all that gladhanding unless you were. But this means they are especially vulnerable to the mere exposure effect; the problem with agreeable folk is that they can agree with the wrong people.

In this sense, directorships and consultancies are very different from other types of work. Writing newspaper articles, for example, is a solitary job which doesn't expose you to the influence of the rich*.

You might reply here that this form of exposure is only one of countless ways in which the rich gain undue political influence.You'd be right. But this is another reason to welcome Miliband's proposal. It invites the questions: in what other ways do the rich have excessive power and how might we combat this? In this sense, he is both putting a good issue on the agenda, and perhaps introducing a building block policy - an apparently modest policy which creates the potential for more radical ones later. For this reason, I applaud him.

* The counterargument to this is that some directorships don't do so either - for example, in small family firms. But legislation should take account of this.

February 25, 2015

I probably shouldn't say so in these censorious times, but I have a little sympathy for Sir Malcolm Rifkind's desire "to have the standard of living that my professional background would normally entitle me to have."

Of course, an MP's salary of £67,060pa is high from most perspectives; it's more than 94% of us earn. But put yourself in his shoes. He's surrounded by senior journalists, lobbyists, businessmen and lawyers many of whom get six-figure salaries, sometimes on the basis of less than astonishing ability. Mightn't an experienced MP feel underpaid relative to them?

In making such comparisons, Sir Malcolm is conforming to a widespread and longstanding pattern - of judging his income relative to his peers, and judging himself accordingly. This is what Adam Smith meant when he said that our desire for wealth arises not so much from a desire for goods but from vanity: the rich man enjoys the attention and sympathy of the world, whilst the poor one feels shame. It's what H.L.Mencken meant when he defined a rich man as one with an income "that is at least one hundred dollars more a year than the income of one's wife's sister's husband." It's what bankers feel when their bonus, however big in itself, is smaller than their peers'. And it's what the (perhaps apocryphal) worker meant when, on being refused a pay rise, asked his boss: "can't you instead give everyone else a pay cut?"

It's widely agreed that relative (pdf) income matters for our well-being - at least among older people. In one of my favorite books on happynomics, Bruno Frey writes:

People are concerned about their position on the income ladder. It is not the absolute level of income that matters most, but rather one's position relative to other individuals (Happiness, p31).

However, there are some things we can do to mitigate the unhappiness we feel about others' high incomes, for example:

1. Remember that what we don't see can be as important as what we do. The businessman's and barrister's high income is visible. What's not so visible, though, is their stress and long hours. But on these dimensions, Sir Malcolm has the advantage; as he said, he has time on his hands.

2. Realize that higher income has only modest effects upon happiness. As Smith said of the ambitious man:

It is in the last dregs of life, his body wasted with toil and diseases, his mind galled and ruffled by the memory of a thousand injuries and disappointments which he imagines he has met with from the injustice of his enemies, or from the perfidy and ingratitude of his friends, that he begins at last to find that wealth and greatness are mere trinkets of frivolous utility.

The difference between the most dissimilar characters, between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom, and education. When they came into the world, and for the first six or eight years of their existence, they were perhaps,very much alike.

Why, then, not compare your income to the porter's?

4. Remember that income is not a measure of merit, and so a low income, relative to others, is not a sign of low personal worth. In saying this, I'm not making a leftist point.It was Hayek who said that, in a market economy, "the return to people’s efforts do not correspond to recognizable merit." (Law, Legislation & Liberty vol II p72)

Sir Malcolm, however, seems not to have adopted these coping strategies. Instead, he tried to solve the problem by scrabbling about for a few quid and in doing so has lost dignity and esteem. For this reason, he deserves a little sympathy.

February 24, 2015

The juxtaposition of David Cameron's claim that we have a "fundamental duty" to care for pensioners with the FT's story that 20-somethings have low incomes after housing costs reminds us that intergenerational justice is now a big issue.

But I wonder: is this partly a product of secular stagnation?

To see my point, consider a reasonably typical exchange between a youngster and oldster:

Oldie: You guys are lucky. You have smartphones, tinder, spotify and free books and music - and less sexism, racism and homophobia than in my day.Youngster: But I can't afford anywhere to live.

The oldster is telling a story about progress, the youngster one about diminishing returns: you can think of high house prices as evidence of Ricardo's claim that economic growth would raise land prices and rents.

In fact, you can think of economic history as a fight between diminishing returns and technical progress. Diminishing returns reduce productivity and raise relative prices; technical progress raises productivity and reduces relative prices.

Now, if technical progress wins the race, things look dandy for youngsters. We can tell them:

You'll enjoy many more new technical breakthroughs that we oldsters won't live to enjoy. You should also see rising real incomes. And because productivity rises, the "triple lock" on pensions will be sustainable. This means it will benefit you more than today's oldies - simply because 50 years of rising real pensions is better than ten years of them. It's even possible that teleworking will depress house prices in future in the same way that the spread of commuter railways did before WWII, so you needn't worry about high house prices. Heck, you might even get to live very much longer - and this beats everything.

If, however, diminishing returns win out, then this doesn't apply. Instead, youngsters face stagnantish real incomes and more unaffordable housing, whilst generous state pensions will prove to be unsustainable.

This is what I mean when I say that intergenerational justice is on the agenda now in part because of secular stagnation*. It's the threat of this that gives youngsters a grievance.

You don't have to be a Marxist to see that the economic climate influences social and political issues: as Ben Friedman showed, booms make people tolerant and slumps make them racist and mean. What we're seeing with intergenerational justice on the agenda might just be an example of how stagnation is shaping politics. There might well be other examples to come - and Friedman's work suggests they'll not be nice.

* Rick might be right to say that stagnation represents a return to normal. For example, according to Angus Maddison's data, UK real GDP per capital grew only 1.3% pa between 1830 and 1913. On the other hand, though, this might be the final crisis of capitalism.

February 23, 2015

Is Harry Kane really the new Alan Shearer? Or is he simply this season's Michael Ricketts? The question is crying out for an application of Bayes theorem.

I say so because otherwise we risk being misled by cognitive biases.

One of these is a sampling bias; we tend to draw excessively strong inferences from small samples: lots of players look good when they are on form, but it is wrong to infer from this that the player is a genuine world-beater. Only very silly managers buy players on the strength of a highlights video.

Another is wishful thinking. Spuds want to believe Kane will be a an all-time great. Gooners do not, with some suggesting that "great Sp*rs player" raises the same sort of philosophical issues as Bertrand Russell's golden mountain*.

One way of correcting such biases is to use maths. Enter Bayestheorem. This is:

P(A¦B) = [P(B¦A) x P(A)]/P(B)

Let P(A) be the probability of having a new great player. And let P(B) be the probability of us seeing a player doing what Kane has done this season. P(A¦B) is then the probability of us having a new Shearer, given Kane's performances.

Let's put some numbers on this.

Over 3500 players have appeared in the Premier League since its inception. Only a handful, though, can be called true greats of the Shearer/Henry type. So let's call P(A) 0.5%.

P(B¦A) is the probability of a player delivering Kane's performances if he were a true great. Kane has scored 24 goals in 37 appearances this season - a goals per game ratio of 0.65. This is more than Shearer or van Nistelrooy managed in their career, but less than Henry. It is therefore the sort of thing a great would do. Let's call this probability one.

P(B) is the probability of a player doing what Kane has done this season. A binomial distribution tells us the chance of someone scoring 24 in 37 games if they were really only a 0.4 goals per game player is tiny - just 0.2%. However, there are lots of players in the league, so the chance of someone having a great season if they were ordinary is much higher than this. Let's call it 1.5 per cent. This captures the fact that there are many young players who briefly shone but sank into obscurity: remember Franny Jeffers, Danny Cadamateri, Seth Johnson, Michael Bridges...?

If we put these numbers together, we get:

[1.0 x 0.005]/0.015 = 0.333

In other words, there's a one-in-three chance of Kane being a true great. I suspect this splits the difference between what Spuds want and what Gooners want.

Now, I don't intend this to be a precise answer: think of it instead as a Fermi estimate. Instead, I say this to illustrate a general point. Maths isn't useful merely because it gives us precise answers. It can also be used as a way of cautioning us against egregious biases.

* This is not the only link between philosophy and Sp*rs. A.J. Ayer - Nigella's stepdad - was a keen Spud. Gooners devised the chant "Who's that team they call the Arsenal?" to wind him up.

February 21, 2015

In a superb piece Frankie Boyle raises the question of what counts as punching up:

You might have imagined that routines "punching up" against the big targets of the day would have to involve the international banking system; the arms industry; or even just the fact that the entire world is about to disappear screaming under boiling waves. To the well trained ear of the English middle classes, an authentic target is more likely to be something like "star signs".

Although "punch up, don't punch down" is a principle of some comedians, it's one I too try to follow, albeit no doubt imperfectly. Punching down is mean-spirited bullying and, when it takes the form of attacking the unemployed or immigration (pdf), it is economically ill-informed blaming the victim. Richard Murphy on the other hand might have his faults, but he is to be admired for punching up.

It's in this context that I found Brendan O'Neill's complaint that identity politics has created an army of narcissistic cowards so irritating. "Narcissistic cowards" is a good phrase. But isn't it a better description of big business? It's narcissism to believe that you have the skills to control a big organization from the top down. It's narcissism to believe that you deserve to earn hundreds of times more than your employees. It's cowardice to hide corporate crime and incompetence behind libel laws, PR flummery and advertising budgets. And it's cowardice - in the form of years of being scared to invest - that has given us mass unemployment and stagnant real wages across western economies.

Rather than punch up and attack the big targets, however, O'Neill punches down at student politics.

So much for my instincts. There are, however two caveats here.

One is that punching down does sometimes hit deserving targets. Death threats against Peter Tatchell are to be deplored - though those of us who remember the Bermondsey by-election savour the irony of the rightist and centrist press being so solicitous of Mr Tatchell's well-being. And those beneath us are sometimes guilty of racism, sexism, religious fanaticism and bigotry. These things can't always be blamed on poverty: Josh Parsons (who in being a racist, Chelsea fan and Ukipper has achieved the perfect hat-trick of cuntitude) went to Millfield.

Secondly, what counts as punching down? O'Neill and his like probably believes that he's punching up because he's oppressed by the "PC brigade". When Simon criticizes Osborne's austerity he's punching downwards intellectually, as are many critics of Iain Duncan Smith. This is acceptable because he's punching up politically. But what about when some Ukip candidate is ridiculed for an idiotic statement? Is this reasonable punching up against a politically influential movement, or bullying a hapless inadequate?

These caveats mean that the rule "punch up, don't punch down" has many exceptions. Despite this, I'm going to try to stick to it. One justification for doing so is simple cognitive diversity: whilst there's never a shortage of people willing to punch down, there often is of those willing to punch up.

February 20, 2015

He, who before was the money-owner, now strides in front as capitalist; the possessor of labour-power follows as his labourer. The one with an air of importance, smirking, intent on business; the other, timid and holding back, like one who is bringing his own hide to market and has nothing to expect but — a hiding.

And here's a recent paper by Nikos Nikiforakis, Jorg Oechssler and Anwar Shah:

We have designed a game in which exploitation can result from the hierarchical relationship between players and, in particular, from the fact that the senior worker has the power to coerce a junior worker into exerting high levels of effort. Using a laboratory experiment, we find that senior workers often attempt to exploit junior workers.

This is not an isolated finding: it's consistent with an earlier paper by Ernst Fehr and colleagues.

The question is: what is the external validity of these laboratory findings?

On the one hand, Marx's critics - following Coase (pdf) and Williamson - might argue that hierarchy increases aggregate output and this benefits workers sufficiently to offset opportunistic exploitation. This, however, runs into the problem that cooperative firms can be more efficient than more hierarchical ones.

On the other hand, though, one might argue that the Nikiforakis, Oechssler and Shah paper actually understates the problem. In lab experiments, the payoffs to both parties are small which means that exploitation is mitigated by a norm of fairness. In the real world, however, the payoffs to exploitation are big enough to overwhelm that norm. This is especially the case to the extent that narcissistic bosses' over-inflated sense of entitlement might mean that they feel entitled to extract big rents.

Now, there was a time when the Labour party had an answer to these problems. In the post-war period, it thought that full employment and strong trades unions would give workers a form of countervailing power to resist the tendency for hierarchical capitalism to generate exploitative rent-seeking. Today, though, it's answers - insofar as it has them at all - seem rather weaker.

February 19, 2015

Why does the Left get to pick which issues are the benchmarks for “science”? Why can’t the measure of being pro-science be the question of heritability of intelligence?

I don't know much force this question has: maybe some lefties do reject the heritability of IQ on ideological grounds. I want to make another point - that there's no need for them to do so. You can accept that IQ (or ability generally) is heritable and still be a strong egalitarian.

I say this because of a simple principle: luckegalitarianism. This says that inequalities are unjust if they are due to circumstances beyond one's control. If we grant that ability is inherited, then differences in ability are obviously a matter of luck. Insofar as these give rise to inequalities of income, a luck egalitarian can thus claim they are unjust.

In this context, Tim's claim that the high intergenerational elasticity of wealth (pdf) uncovered by Greg Clark might be due to inherited ability rather than inherited wealth is irrelevant. The luck egalitarian can reply: it doesn't matter whether what is inherited is wealth, ability, cultural capital or whatever. Whichever it is, it's a matter of sheer luck and thus unjust. There is therefore a moral case for equalizing such inequalities - though whether there's an economic case is another matter.

And sure enough, there is some evidence that our economic fate is heritable. Not only do we have Clark's findings, but there's also evidence of high heritability of long-term incomes, and evidence that savings rates and hence late-life wealth inequalities are partly genetic.

That said, there is a sort of leftie who would be discombobulated by the heritability of ability. I'm thinking of that sort, like Tessa Jowell, who - in their optimism about the malleability of humankind - think that education can significantly reduce inequality.

Of course, some of you might want to reject luck egalitarianism; feel free to argue against Richard Arneson's defence (pdf) of it: surprisingly, laboratory experiments show that few people actually are luck egalitarians.

My point, though, is merely that there's no conflict between leftism and a belief in the heritability of ability. In this respect at least, the left has nothing to fear from science.

February 18, 2015

Today's labour market figures didn't just tell us about aggregate employment and wages. They also contain some less-noticed but also important data.

First, there are labour market flows - the numbers moving between employment, unemployment and inactivity. These show that:

- 338,000 people moved from employment to unemployment in Q4. This implies that 1.1% of those in work lost their jobs and didn't get another; this of course understates job insecurity to the extent that many who lose a job find another in the same calendar quarter, and because...

- 524,000 moved from employment to inactivity. In other words, most of those who lost their jobs in Q4 did not become unemployed. Many of these transitions would have been voluntary, such as folks retiring. But it's also the case that these moves include those who lost their jobs through illness or who just dropped out of the labour market.

- 491,000 people moved from inactivity to employment - equivalent to 21.6% of the inactive who wanted work in Q3. This compares to 522,000 moving from unemployment to work (26.6% of Q3's unemployed). This tells me that the inactive are a big source of labour. This implies that potential labour supply is much greater than official unemployment figures suggest: there are 2.28m "inactive" people who want a job compared to 1.86m officially unemployed. This, allied to falling productivity, makes me doubt whether real wages can rise by much.

We also got data on employees by socio-economic category (table EMP11 here). These show that, in the last 12 months, employment has shifted downmarket. The numbers in "routine occupations" rose by 7% whilst the numbers in the higher managerial and professional class fell by 0.2%. Since employment troughed in Q12010 routine occupations have risen 14.7% whilst the higher managerial and professional category has risen 8.7%.

We also have data on full-time wages by occupation. These show that wages of professionals have fallen in nominal terms in the last 12 months, by 2.1%. Wages of skilled trades, though, have risen 5.1%; given that employment of them has risen 6.1% this could be evidence that skill shortages are raising some wages. Wages of sales staff have gone up by 6.2%, although the numbers of them have fallen slightly. Since the Q1 2010 trough in employment, though, managers' pay has outstripped others, rising by 14.6% compared to an average of 6.6%.

We also have numbers on employment and self-employment by occupation. These show that since Q1 2010, employment of professionals has risen 10.4% and that of elementary occupations has risen 8.8%. Administrative and secretarial employment, however, has fallen. This is evidence of jobpolarization.